Fed confused about what drives inflation

On October 4 2017, the former governor of the Federal Reserve Daniel Tarullo in a speech at the Brookings think-tank in Washington said Fed policy makers do not have a reliable theory of what drives inflation. According to Tarullo, central bankers should pay less attention to theoretical models and more to actual data. However, how is it possible to make any sense of the data without having a reliable theory?

 

The importance of theory

The purpose of a theory is to enable to ascertain the definition of a phenomenon that is subject to investigation.

The correct definition attempts to identify the essence of the phenomenon i.e. the key parts that drives the phenomenon.

For instance, the definition of human action is not that people are engaged in all sorts of activities, but that they are engaged in purposeful activities – it is purpose that gives rise to an action.

So when Tarullo states that Fed policy makers do not know the causes that drive inflation he basically says that Fed policy makers have not as yet established the correct definition of inflation.

Is it then valid to be practical, as suggested by Tarullo, to focus only on the data to understand what inflation is all about? If Fed policy makers respond to changes in price indices without establishing what drives these changes this runs the risk of making things much worse.

 

Attempting to define what inflation is all about

The subject matter of inflation is embezzlement by means of diluting the purchasing power of individuals. The source for this act of embezzlement is increases in money supply out of “thin air”. The increase in money out of “thin air” sets in motion an exchange of nothing for something or the diversion of real wealth from wealth generators to the holders of the newly created money.

Hence the heart of inflation is increases in money supply out of “thin air”. It is these increases that set in motion the act of embezzlement of wealth generators.

As a rule the diversion of real wealth by means of increases in money out of “thin air” tends to be manifested by general increases in prices. However, if the rate of increase in money supply corresponds to the growth rate of goods and services then no general increase in prices will emerge.

Irrespective of the fact that no general increase in prices took place, inflation here is not depicted by unchanged prices but by the increases in money supply.

Hence, drawing conclusions from supposedly stable price indices i.e. being practical as suggested by Tarullo, results in the complete misreading of the economic map.

This has in fact been the case in the past. By defining inflation as increases in price indices rather than increases in money supply, the onset of the Great Depressions of 1930’s caught most economists by surprise since price indexes were stable at that time.

On this Rothbard wrote (America’s Great Depression, p. 153),

“The fact that general prices were more or less stable during the 1920’s told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware.”

According to Mises (Inflation: An Unworkable Fiscal Policy p99 in Economic Freedom and Interventionism)

“Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term “inflation” to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation.”

 

The popular definition cannot explain why inflation is bad news

If inflation would have been just a general rise in prices then why is it regarded as bad news? What kind of damage does it do? Mainstream economists maintain that inflation, which they label as a general rise in prices, causes speculative buying which generates waste.

Inflation, it is maintained, also erodes the real incomes of pensioners and low-income earners. It also causes a misallocation of resources, so it is claimed.

Despite all these assertions regarding the side effects of inflation, mainstream economics doesn’t tell us how all these bad effects are caused. Why should a general rise in prices hurt some groups of people and not others?

Why should a general rise in prices weaken real economic growth? Or how does inflation lead to the misallocation of resources? Moreover, if inflation is just a rise in prices, surely it is possible to offset its effects by adjusting everybody’s incomes in the economy in accordance with this general price increase.

However, if we accept that inflation is about rises in money supply and not a rise in prices then all the above assertions can be easily explained.  It is not the symptoms of a disease but rather the disease itself that causes the physical damage. Likewise it is not a general rise in prices but rises in money supply that inflicts the physical damage on wealth generators.

Since increases in money supply set in motion an exchange of nothing for something, it diverts real funding away from wealth generators towards the holders of the newly created money. It is this that sets in motion the misallocation of resources and not price rises as such.

Moreover, the beneficiaries of the newly created money i.e. money “out of thin air”, are always the first recipients of money. For they benefit from diverting a greater portion of wealth to themselves. Obviously those who don’t receive any of the newly created money or get it last will find that what is left for them is a diminished portion of the real pool of wealth.

Furthermore, real incomes fall not because of general rises in prices but because of increases in money supply i.e. inflation depletes the real pool of wealth thereby undermining the production of real wealth i.e. lowering real incomes. General rises in prices, which follow rises in money supply, only points to the erosion of money’s purchasing power – however general rises in prices by themselves do not undermine the formation of real wealth as such.

As a result of an erroneous definition of inflation, some economists argue that low inflation is a precondition for healthy economic growth. For them inflation is bad news only when it reaches high figures (George Akerlof, William Dickens, George Perry “Near Rational Wage and Price Setting and the Long Run Phillips Curve in Brooking Institution study 2000). If a general rise in prices is the outcome of a rising money stock, how can it benefit the economy if it is stabilized at a low level? Surely the rising money stock that dilutes the real pool of wealth cannot be good for economic growth.

 

Friedman’s misleading view of inflation

Some economists like Milton Friedman maintain that if inflation is expected then it will be harmless (Dollars and Deficits p47-48).

The problem, according to Friedman, is with unexpected inflation, which causes a misallocation of resources and weakens the economy.

According to Friedman if a general rise in prices can be stabilized by means of a fixed rate of monetary injections, people will then adjust their conduct accordingly.

Consequently, according to Friedman, expected general price rises, which he calls expected inflation, will be harmless with no real effect.

Observe that for Friedman bad side effects are not caused by rises in money supply but by its outcome – rise in prices.

Friedman regards money supply as a tool that can stabilize general rises in prices and thereby promote real economic growth. According to this way of thinking all that is required is fixing the rate of money growth and the rest will follow suit.

It is overlooked by the distinguished professor that fixing the money supply growth rate does not alter the fact that money supply continues to expand.

This in turn means that it will continue the diversion of resources from wealth producers to non-wealth producers even if prices of goods remain stable. In short, the policy of stabilizing prices is likely to generate more instability.